What is Inflation?

School of Financial Wellness

A shopping cart overflowing with coins indicating rising cost due to inflation.

When prices for everyday items increase, it can be more difficult to afford your lifestyle. That’s why, in today’s high inflation environment, Americans are demanding higher wages and investment returns to compensate.

Those on a fixed income have the added challenge of meeting these higher living expenses without the ability to grow their budget. This means it is especially important for retirees to understand, predict, and plan for the effects of inflation. Its impact can be devastating to both their purchasing power and their retirement plans.

What is Inflation and What Causes It?

Inflation occurs when prices of goods and services in an economy increase. When prices rise, the amount of goods and services that can be purchased with a set amount of money decreases. There are many factors that contribute to inflation including input prices, changing consumer demand, and government intervention into markets.

An increase in production prices can also lead to inflation in a particular industry. This can be from an increase in the price of raw materials, or an increase in the cost of bringing goods and services to market – like growing shipping costs or wages. During the COVID-19 pandemic, supply chains were disrupted globally, driving up input prices and leading to widespread delays and price increases.

Increased demand is another factor that can lead to rising prices. When consumers need or want a particular good, and the supply is fixed, the price of the good increases as more consumers compete to purchase it. Along with supply chain shortages, increased demand has driven inflation in key industries since the onset of the COVID-19 pandemic.

The government and the Federal Reserve can also affect inflation. Expansionary fiscal policy, usually employed during an economic downturn, involves the federal government increasing spending or decreasing taxes. Both of these techniques increase demand within the economy by providing additional disposable income to consumers. This can help bring an economy out of recession but can also lead to inflation when demand exceeds its pre-recession level or production cannot keep up with the increased demand. As such, the stimulus payments made to individuals in 2020 and 2021 increased disposable income for many Americans and helped to lift the economy out of recession. On the other hand, these payments increased demand for goods and services which has helped drive prices higher.

Expansionary monetary policy, typically undertaken by the Federal Reserve during a recession, lowers interest rates and makes borrowing funds more attractive. When loans become more affordable, demand for goods and services increases. However, when interest rates remain low after demand has recovered, it can lead to or exacerbate inflation. Interest rates have remained near zero since March of 2020. While low interest rates have helped stimulate the economy and labor market, easy borrowing may have also contributed to today’s high inflation.

Effects of Inflation

Inflation erodes purchasing power.

This can be especially important for those on a fixed income. If prices increase more quickly than income, consumers can’t afford to buy the same amount of goods and services with their current budget.

Inflation can also lead to higher interest rates.

When inflation is high, the Federal Reserve will often raise interest rates to combat the rising prices. This makes loans more difficult to obtain and more expensive.

Inflation leads to more inflation.

When prices continually rise, consumers react by spending money in the short-term rather than saving because they will not be able to buy the goods at their future prices or are unwilling to buy them at higher prices in the future. This leads to more demand, and consequently, more inflation.

Inflation can cause bond yields to rise and bond prices to fall. Bonds are debt instruments issued by governments or businesses. As forms of debt, they pay out interest payments, or coupons. Federal Reserve policies impact interest rates but market forces also play an important role in determining bond yields. When investors anticipate higher inflation, they demand higher yields to compensate for the diminishing purchasing power of coupon payments.

When yields for newly issued bonds increase, the price of current bonds decreases because investors have a choice to invest in a new bond with a higher yield or an older bond with a lower yield. For investors, this means that their current bond holdings are less valuable. It also means that future bond purchases may provide more income.

Inflation today

The Fed’s target for annual inflation over the long run is 2%. The current inflation rate is more than three times the Fed’s target. The inflation rate from October 2020 through October 2021 was 6.2%. Currently, prices are rising much faster than in previous years. Inflation has been relatively low since the 1990s. Average annual inflation from 1990 to 2020 was 2.41%.

In January 2020, prior to the pandemic and Federal Reserve policies which lowered interest rates to near zero, the yield on 10-year treasuries was 1.88%. By April 2020, the yields had fallen to 0.62%. A year later, market forces had pushed rates to 1.69%. On November 15, rates for 10-year treasuries were 1.63%.

While nominal yields have increased from pandemic lows, when adjusted for inflation, many bond yields have not maintained their purchasing power. The real yield, adjusted for inflation, of 10-year treasuries was 0.08% at the start of 2020 and was -1.13% as of November 15.

How Inflation Impacts Retirement Income

Social Security and some pension incomes are adjusted for inflation with annual Cost of Living adjustments [COLAs]. These adjustments can help retirees compensate for rising prices but often lag behind price increases. For Social Security, COLAs become effective each January but are based on increases in the Consumer Price Index from the previous year. For 2022, the Social Security COLA is 5.9%. This is based on the inflation rate from the third quarter of 2020 through the third quarter of 2021. While the increase in benefits is helpful for those on a fixed income, there are usually several months where retirees have to pay inflated prices before the COLA takes effect.

During retirement, many investors shift their holdings away from volatile growth stocks and towards income producing stocks and bonds. As previously stated, bond yields tend to rise when inflation is high, increasing income in the long run. However, prices for goods and services may increase more quickly than bond yields and the real return of bond investments may not keep pace during periods of high inflation. Maintaining a balanced portfolio including both stocks and bonds may help investors’ returns outpace inflation in the long run.

See How Your Retirement Plan Might be Affected by Inflation

If you are looking for help understanding how inflation could impact your income during retirement, contact an advisor at Meld Financial. Our team of experienced financial professionals can help you build your Financial Fingerprint™. This is a comprehensive financial plan that is quick to assemble, easy to understand and simple to modify as your circumstances change.

At Meld Financial, our team of our team of financial, legal, and tax professionals work together to develop a wealth management plan designed to meet your needs and minimize the impact of inflation during retirement. If you are ready to get started, contact us today.

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